Scanning the horizon: a regulatory perspective - Michael Hodson, Director of Asset Management and Investment Banking

Remarks delivered to Financial Services Ireland and City of London Dialogue event

Introduction

Good afternoon ladies and gentlemen.

I want to thank you for the invitation to speak at today’s Financial Services Ireland / City of London Dialogue event.

In my remarks, I will spend some time discussing the role of regulatory authorities and how this role moves in line with a changing world.

I will then provide you with an insight on what the Central Bank is doing with regards to sustainable / green finance.

Regulatory role of the Central Bank

If I can start by speaking briefly about the regulatory role of the Central Bank and how this role is evolving in line with today’s financial system.

In preparing for this speech, it occurred to me that it is now nearly 11 years since the financial crisis of 2008 took hold and in looking to articulate the role that we fulfil as regulators today, I am reminded of that wise saying “those who cannot remember the past are condemned to repeat it”.

Undoubtedly, there are a number of lessons to be learned from this period of crisis and I would like to think that both industry and regulators alike have taken lessons on board in the time that has since passed.

The Central Bank for instance has undergone significant organisational change since the crisis with changes introduced to the regulatory framework, our culture and our approach to supervision. For example, in 2011 we introduced the Probability Risk and Impact SysteM, commonly referred to as PRISM, which is at the heart of our risk-based approach to supervision.

More recently, in 2017 the financial regulation pillar of the Central Bank was split into two separate pillars:

• The Prudential Regulation Pillar which is responsible for the supervision and regulation of credit institutions, insurance firms and the asset management / investment banking sector.
• The Financial Conduct Pillar which is responsible for securities and markets supervision, consumer protection and enforcement.

Today, two years after this change, it is safe to say that both pillars are embedded within our day to day functions, they are central not only to our philosophy of intrusive conduct and prudential supervision, they also underpin all that we do as a collective or “One Bank” to fulfil our mission statement of serving the public interest by safeguarding monetary and financial stability and by working to ensure that the financial system operates in the best interests of consumers and the wider economy.

Evolution of supervision

Of course, the financial system as we know it does not stand still, it is adaptive and constantly changing at pace.

And as regulators, although we cannot predict the future, we do have a duty to regulate supervised entities in an informed manner. This means that we aim to future proof our regulatory approach by ensuring that we are:

1. Alive to the dynamics and trends that are currently visible or predictable¹.
2. Assessing the implications of such advancements in terms of risks and opportunities presented.
3. Ultimately updating our supervision approach to ensure that we can continue to meet our mandate in the context of a changing financial services sector.

With that in mind, perhaps I can give you an insight on some of the dynamics that we are seeing and on how we as regulators adapt in line with this unfolding future.

• Firstly, I think it is important to refer to the nature of the financial services sector. Inevitably, Brexit is changing the shape of the financial services sector across the EU.

In Ireland for example, we are presented with the changing face of the asset management / investment banking sector. We are now seeing significant growth in the number and complexity of firms operating here and this extends across trading venues, systematic internalisers and electronic traders.

More generally, we are also witnessing a dispersion of activities across the EU, which historically may have been concentrated in London. This creates the need for national competent authorities across the EU to find tools and mechanisms to get a holistic view of the supervisory risks.

What is more, these developments highlight just how important it is for Central Bank staff to remain active at EU fora. This is necessary to ensure the continued protection of the single market and EU clients.

In this context, speaking from my own experience of participating at an ESMA level, I have seen first-hand how discussions taking place at ESMA’s Supervisory Coordination Network can foster consistency across member states.

If we take fund management companies as an example. Ireland is a jurisdiction that has built-up a sizeable funds industry and today it is home to a strong eco system of service providers that provide a critical role supporting the funds industry. It is therefore not surprising that a sizeable number of management companies choose Ireland as their post Brexit jurisdiction.

However, we must not forget that the funds that the management companies are responsible for are sold across the EU27 to millions of EU citizens and this rightly means that all EU27 national competent authorities are interested in how these entities fulfil their obligations.

We in the Central Bank demand compliance at all times with the key underlying principle that the management company, irrespective of the use of delegation, remains the party responsible for all aspects of its business. This means that they must have sufficient substance within the EU and be able to demonstrate, on an on-going basis, that they are fulfilling all their responsibilities.

Looking forward, management companies will remain an area of focus for the Central Bank and ESMA, of that I have no doubt.

• Moving on, wholesale financial market activity conducted in and from Ireland and by branches of Irish firms in other jurisdictions has increased in scale and sophistication in recent times. In this regard, last year we embarked upon the design and implementation of a systematic risk-based approach to the supervision of conduct in wholesale securities markets.

We also recently used the framework to commence our supervisory engagement with firms by writing to the CEOs of existing and incoming investment firms and credit institutions. The industry communication² issued in March set out our high level expectations in respect of how these firms should identify, mitigate and manage market conduct risk. I would strongly encourage firms to spend the time necessary to review these expectations and to consider what actions are needed to ensure these expectations can be met on an ongoing basis.

Over the coming months, the Central Bank will continue to develop our framework for wholesale market conduct supervision which will serve as a guide in the creation of a coherent single framework for supervision of conduct in securities markets more generally. Moreover, with a specialised team established to conduct a mix of thematic risk assessments and targeted risk assessments, we will also drive forward with our industry engagement.

• Furthermore, Data is something that is high on the regulatory agenda at an ESMA level and we in the Central Bank are strong supporters of ESMA’s recently established Data Standing Committee.

As this committee takes shape, it will work on issues relating to reporting of transactions, positions, record-keeping of orders and instrument reference data; and in discussing such issues, it will provide a forum for enhancing the quality of the market data reported to EU national authorities and trade repositories.

Closer to home, as a knowledge-based organisation, the management and analysis of data has become a critical part of the work we do in the Central Bank. It is therefore essential that we continue to progress in developing our data analytical capabilities.
This has recently been demonstrated with the launch of a new Directorate, the Prudential Analysis and Inspections Directorate, to enhance and support the day-to-day supervisory efforts across the realms of analytics and inspections.

Notwithstanding the above, it is also critical that the data we receive is accurate and reliable. Specifically, in the context of MiFID II, our Market Surveillance Team is proactive in engaging with supervised firms on the accuracy and completeness of data submitted.

The analysis of such data is becoming an increasingly important part of our engagement and provides us with pertinent insights into the activities of the firms we supervise most notably in the areas of transparency, the growth of alternative liquidity sources such as periodic auctions and systematic internalisers and the use of algorithmic trading strategies.

• FinTech, at a broad level, refers to technology enabled innovation in financial services. It is something that my colleagues and I have spoken about on numerous occasions so I will not dwell on this topic in any great detail today.

What I will say is that, we recognise the benefits associated with innovation and advancement in financial technology. Of course, better serving consumers and firms operating more effectively are welcome outcomes. However, as regulators we are also aware that advancement in the FinTech space raises new risks and challenges that we need to consider.

In light of this, last year the Central Bank launched an Innovation Hub to serve as our point of contact with industry and to gather intelligence on FinTech firms and new innovations. In this regard, you may be interested to hear that we recently published a report³ looking back at the operations of the Innovation Hub for 2018. The report outlines the trends we have seen from our engagements with innovators and its publication also served as an opportunity to increase awareness and ensure that innovators know that they can contact us and that we are accessible. Going forward, we intend to build on this intelligence with further annual reports.

Furthermore, throughout 2019, the Central Bank continues to engage with innovators through our Innovation Hub, and this has proven to be extremely useful in enhancing our understanding of how technology is impacting financial services and effecting business models.

• Underpinning the above both from the perspective of FinTech and data is the requirement for firms to have appropriate IT Risk management in place.

IT risk management should be implemented as an enabler to a firm’s business model which is becoming more data centric and requires better governance of data both in terms of quality and security.

To this end, across the broad spectrum of firms that we supervise today, we are seeing increasing dependence on technology and we are also seeing the increased need for firms to improve their cybersecurity.

In the Central Bank’s 2019 to 2021 Strategy, we refer to our mission of serving the public interest by safeguarding monetary and financial stability and by working to ensure that the financial system operates in the best interests of consumers and the wider economy.

In turn, one of the strategic themes of this three year strategy is resilience. And as supervisors, we are actively engaged in the oversight and monitoring of the operational resilience of firms. Consequently, one of our top supervisory risks is cybersecurity risk and its potential impact on firms. In 2016 the Central Bank issued its Cross Industry Guidance on Cybersecurity Risk to all firms in financial services.

Moreover, in the past year our central Technology Risk Team has expanded and this team is now actively supporting supervisors across all regulated firms in addressing IT risks. This includes cybersecurity risk and its potential impact on firms.

The team is currently finalising a thematic inspection across four asset management firms with varying business models, and while we have noticed an improvement in the awareness and engagement of firms to deal with cybersecurity risk, there are still areas where significant improvements are required.

The understanding, oversight and governance of Boards needs to increase in this area in particular with understanding the size and complexities of their IT estates that support their business models. Boards must also be conscious of the increasing role of outsource partners and the need to ensure appropriate due diligence, monitoring and robust challenge on the suitability and the completeness of the services they provide.
Furthermore, the management of the business risks remains with the Board of the regulated firms and to this end firms need to ensure that they have complete and fully operational controls to mitigate cybersecurity risk.

Cybersecurity Risk Management is a practice that is still underdeveloped in the industry, and firms must both identify and manage the variety of threats they are exposed to, whilst recognising that cybersecurity is an ongoing process, not a one-time solution.

To summarise, in fulfilling our role as regulators, it is not our objective to stifle growth or to be a road blockage to future evolution – it is to keep pace with industry and to identify emerging landscapes that can inform our strategic focus in the years to come.

Developing and Strengthening Relationships

So at this juncture, I hope I have impressed upon you just how important it is for regulators to move with the times. Equally important is how we develop and strengthen our relationships with other national competent authorities.

Even today, nearly three years after the referendum, Brexit presents a prevailing sense of uncertainty and clearly there will be some degree of disruption once the global financial services centre that is London is no longer within the EU. However, one thing that I am certain about is that the strong relationship that we in the Central Bank have with our colleagues in the FCA and PRA will continue, regardless of the final Brexit outcome. In the past year for instance, we have completed two secondment opportunities with the FCA.

From a regulatory perspective, a large number of newly authorised and existing Irish entities have connections with sister or parent entities in the UK. It is therefore imperative that supervisory dialogue is maintained between ourselves and our colleagues in the FCA and the PRA. We will continue to share insights and both will benefit from this important relationship.

And, in speaking about relationships, I am conscious that since its establishment in 2015, the Financial Services Ireland / City of London Dialogue has proven itself to be an effective forum that has enabled firms to come together and discuss financial services issues that are of common interest – namely Brexit, CMU and FinTech. It is encouraging that such a forum exists today and I wish you continued success in the future.

European Convergence

Moving on, I am conscious that as an EU member state we must not lose sight of the fact that Ireland falls within the European System of Financial Supervision (also known as the ESFS).

Established in 2010, in the wake of the financial crisis, the ESFS was created to strengthen financial supervision, better protect European citizens and rebuild trust in the EU financial system.

In recent times we have seen a number of important steps taken to achieve these objectives. Examples include: the establishment of the three European Supervisory Authorities (ESAs); the introduction of the Single Supervisory Mechanism to supervise significant banks across the EU banking system; and the implementation of new sector specific legislation such as MIFID II and Solvency II.

Of course, even today, the EU supervision framework continues to evolve. In April, following over 18 months of tough negotiations, political agreement was reached with regards to the ESAs review and it is expected that the agreed amendments to the ESA regulations will be effective from early 2020.

The compromise reached sees the governance of the ESAs amended to give the Chair of the ESAs a vote and an important role in conducting breach of union law investigations and mediation powers.

The Executive Board proposal was amended in favour of giving more supervisory convergence powers to the existing management board and maintaining the decision making authority of the Board of Supervisors.

While on the supervision side, the proposal for funds and prospectus were deleted with ESMA being given critical and third country benchmark supervision and data reporting and market abuse responsibilities. The outsourcing and delegation proposal was also deleted.

In the areas of supervisory convergence, the existing powers have been strengthened with a more formalised peer review structure, new Q&A powers, establishment of supervisory handbooks, and the right to set up mandatory coordination groups. While in the area of consumer protection there are new powers for product intervention, carrying out mystery shopping and retail trend analysis and the formal establishment of consumer protection committees within the ESAs.

From a Central Bank of Ireland perspective, we welcome the increased supervisory convergence and consumer protection powers, and the additional powers given to the EBA and ESMA in respect of AML, benchmarks, data reporting and third country equivalence. Specifically, in the area of supervisory convergence, we look forward, through these enhanced powers, to playing a strong, central and active role in increasing convergence across the Union.

From an operational point of view, these files are going through legal review in Brussels and we would expect the final Parliament vote in Q3, with most of the powers due to become effective in 2020.

I do take the point that with the implementation of such regulatory changes, there are costs to be incurred by both regulators and industry – most notably the time spent getting up to speed with new regulatory requirements and embedding them in your day-to-day operations. However, we must not lose sight of how important it is to foster supervisory convergence across member states.

In short, as highlighted by the Central Bank’s Deputy Governor, Ed Sibley, in a recent keynote address⁴, “harmonised European regulation and supervision are key ingredients to financial stability and confidence in the European financial system”.

Sustainable / Green Finance

Before I conclude, let me briefly turn to sustainable / green finance.

During a recent speech,⁵ Acting Governor, Sharon Donnery, announced that the Central Bank is now committed to “getting active” on addressing climate related financial risks.
As evidence of our activity, the Central Bank has recently joined both:

• The Sustainable Insurance Forum: which facilitates supervisory and regulatory leadership on sustainability challenges and opportunities for the insurance sector; and
• The Network for Greening the Financial System⁶: an international network of Central Banks and supervisors “willing, on a voluntary basis, to exchange experiences, share best practices, contribute to the development of environment and climate risk management in the financial sector”.

The enhanced dialogue and information exchange these fora afford is of great value to the Central Bank and we will continue to engage in these, and other, international networks on this issue.

We are also active at an EU level in contributing to the implementation of the Commission’s Action Plan for Financing Sustainable Growth through our engagement at the ESAs. This Action Plan aims to boost private capital flows toward sustainable investments through, in part, enhancing transparency to end investors on the sustainability of their investments.

Political agreement has recently been reached on two proposed Regulations arising from the Plan, on sustainable benchmarks and disclosure requirements. This latter Regulation⁷ requires firms to disclose:

• The procedures they have in place to integrate environmental and social risks into their investment and advisory process;
• The extent to which those risks might have an impact on the profitability of the investment.
• Where institutional investors claim to be pursuing a "green" investment strategy, information on how this strategy is implemented and the sustainability or climate impact of their products and portfolios.

Later this month the Commission’s Technical Expert Group will issue its final reports on the development of an EU Taxonomy for climate change mitigation and climate change adaptation and also, on recommendations for the development of an EU Green Bond Standard. The latter will increase transparency and build confidence in the green bond market and potentially increase institutional and retail investor interest in green bonds.

Considering these developments, the increased focus among the EU and international regulatory community on sustainability and also the recent speeches and publications this year at the Central Bank, it is clear we are now active in this space, with our levels only set to increase going forward.

Conclusion

I will stop there.

I have only briefly touched on Brexit in today’s speech.

In doing so, I hope that I have demonstrated that despite Brexit being a seismic event for the financial services sector in Europe and beyond, it does not change the underlying principle that we all remain connected.

We are a global industry and the relationships that we have built up will be equally, if not more important, in the years to come.

It is therefore incumbent on all of us to maintain and nurture the many key relationships that have been established over the years.

With thanks to Adrian O’Mahony, Philip Brennan, Scott Hanson, Sharon Cunningham, Stephanie Kearns, Steuart Alexander and Thomas Farrell for their assistance in preparing these remarks.

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¹ Cross, Gerry: Fit for the future: some current issues in the regulation of Irish investment funds (4 October 2018).

² Central Bank of Ireland: Wholesale Market Conduct Risk – Industry Communication (PDF 693.85KB) (11 March 2019)

³ Central Bank of Ireland: Innovation Hub 2018 Update (PDF 493.94KB) (2018).

⁴ Sibley, Ed: The Irish Funds Industry: Opportunities and Challenges (23 May 2019).

⁵ Donnery, Sharon: Risks and opportunities from climate change (16 May 2019).

⁶ Banque de France: Network for Greening the Financial System.

⁷ European Council: Sustainable finance: Presidency and Parliament reach political agreement on transparency rules (26 March 2019).